(Public) A Trump Victory? Fannie Mae Preferreds
By: Jon Costello
This is part 1 of the 2 part report.
Federal National Mortgage Association—better known as “Fannie Mae”—preferred stock issues are my favored way to profit from a Trump victory in November.
Trump is leading in the polls and betting markets. If he wins, Fannie preferreds stand to gain more than four times their current price over the next few years.
The catch is the binary nature of the situation. If Trump wins, the likelihood of big gains is high. If he loses, however, investors will lose 50% to 75% of their investment, potentially permanently.
Fannie preferreds are therefore only suitable for investors with a strong risk tolerance.
I should add that as an energy investor, I have clients who are concerned that a Trump victory will bring higher global oil supply and lower oil prices. I don’t subscribe to this view. Nevertheless, big returns from the preferreds would offset losses in an investment portfolio stemming from lower oil prices during a Trump presidency. The preferreds therefore offer a way to hedge this potentially negative scenario.
My favored preferred issue is the Fannie Mae Series S (OTCQB:FNMAS). Its offering circular can be accessed in this link. FNMAS is the most liquid and is widely held by the public. Its terms stipulate an annual dividend that resets quarterly at the greater of 7.75% and three-month LIBOR plus 4.23%, though its dividend has been eliminated since 2008. The issue currently trades at around $5.20 per share and has a par value of $25.
I believe the odds are good that the preferreds trade close to par amid a successful recapitalization and privatization of Fannie Mae.
Thesis Overview
The Fannie Mae preferred stock investment thesis revolves around the probability that, first, Trump wins the election, and second, he arranges a recapitalization and release of the company into private hands before the end of his term. Given the necessity for Fannie to raise capital from current levels and to execute the various activities necessary to prepare for private ownership, I expect the process to take three years.
The preferreds are trading at $0.21 on the dollar. Chances are good they get called at par or converted to common on favorable terms. In this article, I’ll focus on the events that I believe indicate that a recapitalization will occur under a Trump administration. My next article will discuss the details of the recapitalization process.
The chart below shows the historical pricing of FNMAS since it was issued in December 2007. Government actions during the financial crisis eliminated the dividend and decimated its price. Since then, its price has fluctuated in line with the odds of a “recap and release” plan being executed.
FNMAS’s price remained depressed through most of President Obama’s terms. However, it showed signs of life during the first Trump administration, as shown in the following chart.
I expect a Trump victory to cause the preferreds to trade at levels last seen in the 2016-2020 timeframe, likely above $6.00. The share price will continue to discount all sorts of hazards standing in the way of a best-case scenario for shareholders. As that outcome becomes more probable, I expect them to trade into the teens and, eventually, closer to par.
In what follows, I sketch why I believe the recap and release scenario makes sense, and why I believe it’s the most probable outcome under a second Trump term.
First, some background on the GSEs.
GSE Background
Fannie Mae and its smaller sibling, the Federal Home Loan Mortgage Corporation—or “Freddie Mac,” are essentially insurance companies. They do not originate loans or lend money like banks. Rather, they purchase mortgages from domestic banks, package them into mortgage-backed securities (MBS), and sell them to investors in the secondary mortgage market. Originating banks exchange their mortgage loans in exchange for insured MBS. The insurance guarantees the timely payment of interest and principal to the MBS owners.
Combined, the GSEs buy about half of all mortgages from lenders, package them as securities, and insure them against loss. Half of GSE-insured mortgages go to first-time homebuyers.
Fannie and Freddie earned the title of “government-sponsored enterprises” (GSEs) due to their implicit government backing in the run-up to the financial crisis.
As private entities, their business model is akin to that of regulated utilities. They operate in a public-private partnership that, while by no means perfect, has been remarkably successful for decades. Of course, the glaring exception was during the financial crisis.
Today, the GSEs are wards of the state, so their government backing is explicit. Due to their central role in the mortgage and housing markets, they cannot be allowed to fail without catastrophic consequences to the global economy.
While critics of the GSEs often favor winding down the GSEs and replacing them with alternative government agencies, I believe the GSEs are irreplaceable. Moreover, the financial system and economy would be better served if they were private rather than permanently housed in the government. The following are among the reasons why.
The GSEs are essential to the existence of the 30-year fixed-rate mortgage. Before Fannie and Freddie, mortgages required large down payments. Loans were almost always short-term, as few banks wanted to take the risks involved in holding loans over a multi-decade period. Mortgages were structured as balloon loans, with a large payment at maturity that the borrower would typically meet by refinancing into another mortgage.
The GSEs ensure the health of the MBS market. By providing an option for originating banks to sell their loans while also stabilizing the value of insured MBS held on bank balance sheets, the GSEs facilitate a massive flow of capital for originating new mortgages. Without them, the U.S. banking system would be dominated by a few mega banks. Smaller banking institutions wouldn’t exist.
Fannie and Freddie reduce the severity of economic downturns. Before the GSEs, an economic downturn would bring a spike in foreclosures, which would make the downturn more severe. For instance, if a mortgage owner’s loan came due during a downturn and banks had reduced their lending or altogether withdrew from the mortgage market in response to the poor economy, the borrower could be prevented from refinancing. Foreclosure and repossession would follow. This course of events occurred regularly before Fannie Mae was established.
Fannie and Freddie keep mortgage underwriting standards high throughout the economy. The conventional conforming mortgages insured by the GSEs have to meet strict eligibility standards for purchase. These standards ensure that loans include a down payment and generally conservative underwriting. Well-underwritten mortgages create a stable primary and secondary mortgage market, which, in turn, stabilizes the economy at large.
By keeping the mortgage market functioning smoothly, the GSEs lower mortgage rates compared to a more illiquid system in which loans tend to be kept on bank balance sheets. Lower mortgage rates stimulate demand for housing, with obvious positive effects on the economy.
If privately owned, Freddie and Fannie would put private capital in a first-loss position before the public. Federal bailouts would be less likely. The government would have less influence in the credit provisioning process, which would reduce the likelihood of another systemic financial crisis.
A public stock listing would incentivize management to be focused on profitability and loss mitigation. This would go a long way toward preventing the bureaucratic bloat that results in the sclerosis of government agencies over time.
The GSE Timeline Has Moved in Favor of Privatization
The course of events since 2008 has increased the odds of a recap and release scenario in a second Trump term.
First, some historical context is necessary to understand where the GSEs are today.
Rewind the clock back to 2008. At the time, the proliferation of bad loans raised concerns in the capital markets that the GSEs would not have enough capital to cover their losses. Fears of GSE insolvency slammed the MBS market, a $5 trillion market at the time. MBS prices plunged, causing MBS markets to seize up and exacerbating the stresses in the financial system.
As problems in the mortgage markets hit the economy, the financial crisis increasingly became a political crisis. Moreover, GSE-insured securities were held throughout the world, so GSE solvency issues had international political implications. Washington had to act.
On September 6, 2008, the financial authorities placed the GSEs into conservatorship. The conservatorship required them to work with a newly created regulator, the Federal Housing Finance Administration (FHFA), to reduce losses and improve operations.
The next day, the Treasury Department agreed to backstop GSEs’ losses in exchange for $200 billion of nonvoting senior preferred stock, a line of credit, and a periodic commitment fee. The preferred stock was called “Senior Preferred Stock Purchase Agreements” (SPSPAs) and featured a dividend equal to 10% of the liquidation preference, which was to be paid quarterly. These securities included warrants granted to the Treasury for the purchase of 79.9% of Fannie and Freddie’s common equity upon exercise. The warrants expire on September 7, 2028.
Freddie and Fannie generated losses until 2011. From 2008 to 2011, they drew $191 billion from their government credit line to fund losses and pay dividends to the government.
By 2012, it became clear that the GSEs were set to return to long-term profitability. The turn in Fannie Mae’s annual net income can be seen below.
In August of that year, the Treasury Department amended the terms of the SPSPAs to replace the 10% dividend with a variable dividend equal to each of the GSE’s positive net worth above a specified capital reserve. The reserve was initially set at $3 billion for each GSE. The capital reserve was scheduled to decrease by $600 million annually until it reached zero on January 1, 2018. Essentially, the Treasury would take all of the GSEs’ retained earnings.
The arrangement became known as the “net worth sweep.” Reducing GSE capital levels to near zero almost eliminated the cushion to absorb losses.
Not surprisingly, problems arose as the GSEs became undercapitalized. In 2017, the Trump administration’s newly-passed corporate income tax rate cuts impaired the GSEs’ deferred tax assets, dealing a blow to their capital levels. Congress grew concerned that Fannie and Freddie would be forced to seek another government bailout if the housing market turned down. The FHFA was also concerned that it would take the heat amid another bailout. As a result, Congress and the FHFA allowed the GSEs to retain $3 billion in reserves as a cushion against loss.
Fortunately, the GSEs avoided losses in 2017. Fannie Mae’s net income for the year totaled $2.5 billion. In 2018, Fannie’s net income grew to a healthy $16.0 billion.
With the GSEs returning to health, on March 27, 2019, the Trump administration issued a memorandum that outlined a plan for the Secretary of the Treasury to end the GSEs’ conservatorship. Under Treasury Secretary Stephen Mnuchin, the administration initiated a process by which the GSEs could raise enough capital to return to private ownership.
Source: CNBC, Sept. 12, 2019.
The plan allowed Fannie and Freddie to retain up to $25 billion and $20 billion of earnings, respectively, to build capital. It set the amount of capital the GSEs needed for privatization at $180 billion. At the time, Fannie held $6.4 billion in capital, while Freddie held $4.8 billion. Capital would be built over time through retained earnings.
Hopes for a privatization were now running high. In May 2019, FHFA Director Mark Calabria indicated in media appearances that privatizations could come as early as 2020. Then, in September, the FHFA suspended the net worth sweep to allow the GSEs to build capital.
Meanwhile, the GSEs had more than fully repaid what they had borrowed from the government. A report by the Congressional Budget Office put their dividend payments to the government from 2008 to 2019 at $301 billion, dwarfing the $191 borrowed to cover losses from the financial crisis.
By early 2020, the GSEs had built their capital to $43 billion. Just as privatization was looking probable, the Covid-related downturn created panic in financial markets. Concerns rose about a potential surge in mortgage delinquencies and defaults.
In response to the crisis, FHFA director Calabria effectively ended the privatization process by proposing new capital requirements for the GSEs that were five times above the levels they had at the time. These capital requirements were absurdly onerous, more akin to bank capital requirements. As such, they would have prevented the GSEs from being released from conservatorship for many years.
By the end of 2020, the economy stabilized, and concerns about the mortgage market receded. In January 2021, the Treasury Department and FHFA amended the SPSPAs for a third time. This amendment was intended to “move the GSEs toward capitalization levels consistent with their size, risk, and importance to the U.S. economy.” Its main effect was to eliminate the net worth sweep until the GSEs raised capital to the levels required under the FHFA’s 2020 regulatory capital framework.
The measure was one of the last to be enacted by the outgoing Trump administration.
The Biden administration made no substantive headway toward GSE privatization in terms of policy. In fact, the opposite was the case. President Biden’s appointed FHFA Director, Sandra Thompson, doubled down on the stringent capital requirements for the GSEs. The final rules provide additional obstacles to an exit from conservatorship.
Nevertheless, as the net worth sweep remained suspended, the GSEs continued to build capital. By mid-year 2024, their combined capital stood at $140 billion.
Reasons for Optimism with Regard to Privatization
The problem with returning the GSEs to private hands is the lack of political impetus for such a move. Aside from concerns about home affordability, voters simply don’t care about the GSEs and their status as public or private.
Countering this political inertia is a tried-and-true motivator: money. The government preferreds and the warrants to purchase 79.9% of GSE common have tremendous value that can be realized in privatization.
The government’s own estimates put the value of its stake in the GSEs at $240 billion.
Source: Fiscal Year 2023 Financial Report of the United States Government, Feb. 2024.
The ultimate amount raised by the government through a privatization would depend on the details of a recapitalization plan.
The GSE privatization process faced another problem over the course of the conservatorship. Since the FHFA’s creation in 2008, the agency was not required to answer to any branch of government. The Housing and Economic Recovery Act of 2008 created it installed a director who would serve a five-year term and could only be removed by the president “for cause.”
That changed in 2021 when the Supreme Court ruled in Collins v. Yellen that the FHFA’s structure was unconstitutional, as it violated the separation of powers. The Court held that Congress overstepped its authority in placing restrictions on the President’s ability to remove the agency’s head.
The Court’s ruling wasn’t all positive for Fanne and Freddie shareholders. It found that the FHFA didn’t exceed its statutory authority when it promulgated the net worth sweep with Congress. In short, the net worth sweep was deemed legal. This reduced the probability that equity holders would receive compensation for the government having taken their property.
Despite this setback, the ruling clears the way for a would-be President Trump to remove the existing FHFA Director and install a candidate who will privatize the GSEs.
Trump appears to support GSE privatization. On November 11, 2021, he released a letter addressed to Senator Rand Paul that clearly stated his view. I reproduced the letter below because it’s important for any investor interested in GSE privatization to read it in full.
Source: Donald Trump Letter to Rand Paul, Nov. 11, 2021.
The letter makes clear that Trump favored privatization. He states that it was President Obama’s appointed FHFA Director, Mel Watt, who stood in the way of his administration’s efforst. At the time, Watt couldn’t be removed, but the Collins v. Yellen decision has since changed that.
Most recently, on September 13, the Wall Street Journal reported that “Trump allies” are working on privatization plans.
Source: The Wall Street Journal, Sept. 13, 2024.
The fact that influential Trump supporters Bill Ackman, John Paulson, and Stephen Schwartzman manage funds with exposure to GSE equity and will therefore benefit from a privatization is probably not lost on Trump. That said, I doubt that Trump intends to run for a third term, so he won’t need their support in a future campaign. The extent to which he will make decisions aimed at helping his current backers is anyone’s guess.
As of mid-year, Fannie Mae’s equity was worth $86.5 billion, while Freddie Mac’s was worth $53.2 billion. Fannie Mae’s equity capital stands at 2.0% of its $4.3 trillion in assets. Freddie Mac’s equity capital stands at 1.7% of its $3.2 trillion of assets. While these are robust capital levels, more capital will be necessary to privatize the GSEs in a utility-like form. Since the net worth sweep is no longer in effect, the GSEs will continue to raise capital at a rapid clip of $25-to-$30 billion per year through retained earnings. I expect two or three more years of retained earnings at that level to allow for a privatization.
Conclusion
The important takeaways are, first, that Fannie Mae and Freddie Mac are here to stay, and privatization is indeed a desirable move. The GSEs ensure a well-functioning mortgage market, lower the cost of homeownership, and support economic growth.
Second, since the GSEs were placed into conservatorship in 2008, events have markedly improved the odds of a privatization.
Third, Donald Trump supports privatization and now has the ability to begin the process in earnest.
In my next article, I’ll turn to the details of a privatization.
Analyst's Disclosure: Jon Costello has a beneficial long position in the shares of FNMAS either through stock ownership, options, or other derivatives.